Household Liquidity Risk Management and Insurance Companies’ Investment Behavior

We apply for a funding extension of the subproject "Household liquidity risk management and insurance companies’ investment behavior" that was part of the SAFE Team Project T7.

In our project, we aim to provide a deeper understanding of the link between demographic changes, liquidity risk and household welfare. We construct a model that links a household's demographic characteristics and its need to hedge liquidity risk to the investment behavior of insurers. To ensure a robust framework and appropriate assumptions, we divide our project into two related articles:

In the working paper "Life Insurance and Demographic Change: An Empirical Analysis of Surrender Decisions Based on Panel Data", Irina Gemmo and Martin Götz study the sociodemographic drivers of policyholders' decision to lapse an existing life insurance contract. In a subsequent article “Life Insurance Surrender Risk and Insurance Companies' Asset Allocation”, we analyze in a theoretical framework to what extent insurers' optimal asset allocation depends on lapse risk. So far, this analysis only considers interest rate changes as drivers for life insurance lapses. To link the existing working paper on the drivers of consumers’ lapse decisions to the theoretical model that predicts insurers' optimal asset allocation, we aim to extend the latter by explicitly modeling households' consumption, liquidity shocks und the resulting lapse pattern. Due to Irina's research stay at the Wharton School, her funding within the Team Project T7 was not exhausted and we could not yet execute the described extension.

The article on “Life Insurance Surrender Risk and Insurance Companies' Asset Allocation” starts with setting up a theoretical framework which consists of: (1) households that encounter random liquidity shocks; (2) life insurers that decide on termination fees for insurance contracts and their asset allocation; (3) regulators who impose constraints on termination fees to maximize households’ welfare; (4) a financial market that offers different products to households and insurers depending on the interest rate environment. In a multi-period model, households exhibit different demand for life insurance contracts according to insurance premia, termination fees, and alternative investment opportunities. Insurers have an incentive to maximize their net present shareholder value by choosing an optimal termination fee and an optimal portion of long-term investments, considering households’ demand responses.